Appraising Leased Fee Interest With Major Drugstore Tenant.

[PL1957]

Don't think I've heard of any of these. I doubt any are rated by Standard & Poor's or Moody's. Because they don't have that strong implicit (or explicit) guarantee that comes with a credit rating, I doubt a property with a 10+ year lease to any of those tenants would sell at a cap rate as low as a CVS or Walgreens. That's part of the reason why the leased fee value of your typical drugstore (occupied by CVS or Walgreens) can easily be twice what the fee simple value is. Those tenants are willing to pay a premium for the best corner locations and built to suit buildings. They will also sell at considerably lower cap rates than a typical tenant at market rent.

Oh you youngsters .... That was a list of major drugstore chains that have gone away over the last 20 years. They were the "names" when I got into the business.

 

[Howard Klahr]

That's part of the reason why the leased fee value of your typical drugstore (occupied by CVS or Walgreens) can easily be twice what the fee simple value is. Those tenants are willing to pay a premium for the best corner locations and built to suit buildings. They will also sell at considerably lower cap rates than a typical tenant at market rent.

Thanks for the explanation. I was unaware of how these work. lol

Maybe it you that needs a lesson in S&P ratings, real estate and business cycles as well as history lessons.
Walgreens closing 200 stores
Obamacare Cost Squeeze May Push Rite Aid To Walgreens

Ever heard of Enron? How about General Motors? Lehman Brothers? World Com? CIT? Conseco? PG&E?
So please educate me about S&P and Moody's ratings.

FYI - This is not my first rodeo

 

[Michael S]

Thanks for the explanation. I was unaware of how these work. lol

Maybe it you that needs a lesson in S&P ratings, real estate and business cycles as well as history lessons.
Walgreens closing 200 stores
Obamacare Cost Squeeze May Push Rite Aid To Walgreens

Ever heard of Enron? How about General Motors? Lehman Brothers? World Com? CIT? Conseco? PG&E?
So please educate me about S&P and Moody's ratings.

FYI - This is not my first rodeo

Yes, I missed your initial point there. This is still my first market cycle. I started in real estate a couple of months before Lehman Brothers went under.

Personally I look at some of these deals, especially rural Family Dollar and Dollar Generals, and shake my head. If I had a some cash burning a hole in my pocket buying a metal building in a town of 3,000 in the middle of nowhere with a 10-year lease to Family Dollar would not be my first choice, not at a 7-8% return, probably not at 10%+ return. Or when I see a Walgreens with 5-years left trading at only 200 or so basis points above one with a brand new 25-year lease.

However, we're supposed to reflect the market, and the market has spoken when it comes to the demand for single tenant net leased properties. Every time I think cap rates have bottomed out there's just more money chasing fewer deals and continuing to push cap rates down. 5-10 years from now the fact that an investor delayed paying taxes through a 1031 exchange for that long may not offset the loss from buying a property at a 6% cap rate and having to sell at an 8% cap rate.

 

[NachoPerito]

a typical investor is going to investigate what will happen in 3.5 years. That is not very much time left on a new lease.

Do you have access to annual sales for the drug store? I expect you probably don't, but it isn't a bad idea to ask the manager how the store does compared to others.

You want to get any hint if you can if the store will renew or not. If you miss something and in 3.5 years they move out and the value plummets you may look bad. But I fully admit that a lot of the time we just don't know what will happen in the future.

 

[Howard Klahr]

we're supposed to reflect the market

Do you understand the underlying economics of the net lease market and why premiums are paid for these types of leases?

 

[PL1957]

Do you understand the underlying economics of the net lease market and why premiums are paid for these types of leases?

Often, I'm not sure I understand the economics of these deals. Significant parts of this market seem to be driven by tax avoidance, parts seem to be the chase for any kind of yield, parts seem to be REITs buying up anything they can to place money. I wish I had a cogent explanation for some of the stuff we see.

 

[Michael S]

Do you understand the underlying economics of the net lease market and why premiums are paid for these types of leases?

I like to think so. There are a couple of factors at play. The first is the perceived stability of the income stream because it is guaranteed by a national tenant. The second is the relative homogeneity of the assets which allows for quicker marketing and lower transaction costs. This decreases the illiquidity risk that is inherent in real estate. This is especially important if the buyer is merely parking their money (typically from a 1031 exchange) while they wait to invest in something for the long term. In the case of a company like Walgreens, a new 25-year lease is perceived more like a corporate bond than real estate. There's also a continued desire to place money, either from a 1031 tax exchange or funds raised for investment from public and private REITs and other real estate investors.

 

[Howard Klahr]

You have a basic grasp on the market, it is predominantly driven by 1031 exchange money and institutional players. Knowing that you have to realize that the 1031 money will out pay other participants for non-real estate reasons. Also when looking at cap rates, you need to realize that is not the entire yield to the investor and that there are other factors that influence decisions. But yes, the lack of intensive management, higher liquidity as compared to alternative investments and low credit risk make this a favorable investment choice for the participants in this market sector.

However, as noted in the following article, the tenants are looking to have both sides of the valuation issue.

Walgreens and CVS Declare War on Property Taxes

 

[Michael S]

You have a basic grasp on the market, it is predominantly driven by 1031 exchange money and institutional players. Knowing that you have to realize that the 1031 money will out pay other participants for non-real estate reasons. Also when looking at cap rates, you need to realize that is not the entire yield to the investor and that there are other factors that influence decisions. But yes, the lack of intensive management, higher liquidity as compared to alternative investments and low credit risk make this a favorable investment choice for the participants in this market sector.

However, as noted in the following article, the tenants are looking to have both sides of the valuation issue.

Walgreens and CVS Declare War on Property Taxes

Here in Albuquerque there were 8 drug stores built at good locations throughout the city in 2008 or so. The drug store tenant backed out and the developer was left with 8 brand new vacant drug stores. Over the next couple of years some were sold, some were leased. CVS picked up a few, Walgreens a couple, one was turned into a restaurant (and later back to CVS), another was a hardware store and is now a Chinese Buffet. At one point an investor purchased several of them as a portfolio and allocated different values to each one. The two that were leased to national drug stores (Walgreens and CVS) sold at a substantial premium to the vacant ones or those occupied by essentially local retail tenants. The fee simple properties were allocated about 40-50% of the leased fee ones. I can't think of much better market evidence to show how much leasehold value there is with somebody like Walgreens.

When it comes to property taxes, should that leasehold value be included? Seems like it shouldn't to me but I know there's lots of different laws and rules on assessing property in different jurisdictions.

 

[Gobears81]

Here in Albuquerque there were 8 drug stores built at good locations throughout the city in 2008 or so. The drug store tenant backed out and the developer was left with 8 brand new vacant drug stores. Over the next couple of years some were sold, some were leased. CVS picked up a few, Walgreens a couple, one was turned into a restaurant (and later back to CVS), another was a hardware store and is now a Chinese Buffet. At one point an investor purchased several of them as a portfolio and allocated different values to each one. The two that were leased to national drug stores (Walgreens and CVS) sold at a substantial premium to the vacant ones or those occupied by essentially local retail tenants. The fee simple properties were allocated about 40-50% of the leased fee ones. I can't think of much better market evidence to show how much leasehold value there is with somebody like Walgreens.

When it comes to property taxes, should that leasehold value be included? Seems like it shouldn't to me but I know there's lots of different laws and rules on assessing property in different jurisdictions.

We had a very similar discussion in a thread several months ago. I was accused by two posters of being an advocate for the assessor, despite my property rights adjustment on new leased properties being in the range that you mentioned of the stores selling in 2008. No, the leasehold value is not included in the assessed value, just fee simple. With that said, I recognize that leasehold is a reasonable term for the essential gap between leased fee and fee simple, but it implies that there is a separate market value for this interest, and I don't entirely buy into that. There are two reasons for this. One component of the "leasehold" interest in this case is the above-market rents and the other is the extremely long term lease to a national tenant. You may have above-market rents, but you also have sub-6% rates for a 25-year lease. That rate increases to above 9% in some cases for properties with less than 5-years remaining. Yes, a portion of that discrepancy may be attributed to the property getting older, but in my experience, cap rates do not increase by over 50% for a new vs 20-year-old property unless there are other factors in play. Most national tenants do not sign 25-year leases when the property is constructed, when a 10 to 15-year lease is sufficient for most developers to construct new. I see more +/- 7% cap rates for new properties leased to national tenants when there is a 10-15-year lease. Thus, the other component of the "leasehold" interest is based on the lower than typical cap rate for these long-term leases. You may be able to package the capitalized income based on the above-market rents into a market value and call it leasehold, but could you package the additional value related to the low cap rate as a result of the long-term lease? If the cap on a 25-year lease is 5.5% and the cap on a 10-year lease is 7%, the additional value is 27%, all else equal. Would there be anyone that would buy a 27% interest with no ongoing rental payments? I think not. Thus, I prefer using the term property rights adjustment in this case.

Based on the onslaught received in the last thread for my methodology, I'll probably be criticized for the above post, but whatever. It is my humble attempt at answering your question.